Investors have seen the recent headlines: Historic low yields in U.S. Treasury bonds and negative interest rates in some international bonds. Even the S&P 500 yields less than half its historic average in dividends annually. Low interest rates are great for some things, like mortgages and loans for borrowers, but not so great for investors. For income-focused investors especially, this era of low rates potentially leaves two choices for a portfolio: Earn little or nothing on low-risk investments like government bonds and money market accounts or chase much riskier assets with higher yields, like low-grade corporate bonds.
A recent Forbes survey of 500 individual investors found that this era of low rates is causing worry: 30% are concerned that their current or future income may be lower than they want and another 24% are worried about the growth of their capital. A quarter of all investors are less than confident they’ll achieve their income goals for their portfolio.
In the search for income, investors do have another option—closed-end funds (CEFs), which can play a central role in building a portfolio geared to pursuing income and growth. CEFs are a well-established type of investment traded on stock exchanges and actively managed by portfolio managers. They’re typically managed with an eye toward generating distributions to shareholders regularly, usually monthly, but sometimes quarterly, semi-annually or annually, according to the fund screening source CEFConnect.
According to the Investment Company Institute, the CEF sector paid out $16.4 billion in distributions to investors in 2019. CEFs aren’t as widely held as other investment types, with only 24% of surveyed investors saying they own CEFs, compared to 75% who own a mutual fund or ETF. Yet among investors who say their portfolio income is meeting their expectations, almost 69% own CEFs. Nearly 80% of CEF owners surveyed agreed that CEFs provide attractive income. Often, a CEF could provide better income potential than other investing options.
“If you look at what an asset class pays versus a fund that invests in that asset class, you do get paid. For example, a muni bond might pay 3%, but a national leveraged municipal closed-end fund right now pays 4.5% to 5%, while a mutual fund might pay under 3%,” says Sangeeta Marfatia, senior closed-end fund strategist at UBS Global Wealth Management.
How do CEFs produce income for shareholders? There are a number of ways, and it varies by fund what tools managers opt to use. One of the ways is traditional, fundamental research that identifies assets that produce income and should grow in value. This can result in a CEF that owns a basket of dividend-bearing stocks or bonds that provide straightforward income. Managers often extend a fund’s income creation through sophisticated strategies as well. For instance, many bond CEFs profit on the spread between the low short-term cost of borrowing and the returns they get by buying high-yielding, long-term bonds.
Many CEFs magnify their positions by using leverage to increase exposure to investments that may ultimately increase the portfolio’s income and capital appreciation. Leverage magnifies returns—whether positive or negative—which increases a fund’s risk and price volatility. “Clearly, there is risk for that extra income you’re getting because of leverage,” says UBS’ Marfatia.
Most CEFs do use leverage, but 64 of the roughly 490 CEFs available to investors today don’t use leverage, according to data from CEF Connect. Recently, CEF Connect reported that nearly two thirds of CEFs recently had distribution rates above 5%—and 30% had rates above 9%.
Investors surveyed by Forbes who own CEFs believe the funds benefit their portfolio: Almost 82% of investors who felt their portfolio was prepared for the pandemic crash own CEFs compared to nearly 19% who felt unprepared.
Income investors also are drawn to CEFs because they have some options on how to deploy their investment. Since CEFs are readily traded in the stock market, they allow investors to sell shares during the day to raise money if desired. Some investors may focus on redeploying regular distributions to other needs without necessarily having to sell shares. Yet CEFs also provide the flexibility to reinvest distributions back into the fund, a classic method of building long-term wealth. In fact, the Closed-End Fund Association says it’s not unusual for families to pass their shares down from generation to generation. That’s one way to create a legacy for tomorrow, while generating income for today.
It is important to consider the objectives, risks, charges and expenses of any fund before investing. Investing in closed-end funds involves risk; principal loss is possible. There is no guarantee a fund’s investment objective will be achieved. Closed-end fund historical distribution sources have included net investment income, realized gains and return of capital. Leverage typically magnifies the total return of a fund’s portfolio, whether that return is positive or negative, and creates an opportunity for increased common share net income as well as higher volatility of net asset value, market price, and distributions. There is no assurance that a fund’s leveraging strategy will be successful.
Nuveen Securities, LLC, member FINRA and SIPC